Caution with Canadian Bank Stocks

– By T. Edward Gardiner

For some time now, I’ve been avoiding Canadian bank stocks. I believe they’re over-priced, given the banks’ big exposure to consumer debt.

In spite of this, their share prices have continued to rise, although now, it’s just possible their prices may have peaked.

Meanwhile, the banks recently announced their latest results. Although the Royal Bank of Canada (RY-TSX, $70.80) saw profits jump 11 per cent, the Toronto-Dominion Bank (TD-TSX, $98.93) posted a much smaller increase, while the Canadian Imperial Bank of Commerce (CM-TSX, $89.60) actually showed a slight decrease.

Whether investors were expecting more or whether they’re simply nervous about the sector in its totality, all the banks’ shares took a hit from profit-taking.

Although prices recovered a little over the next few weeks, investors’ reactions may be a sign the banks are no longer the market darlings they once were.

Indeed, investors are getting nervous.

And they have a lot to be nervous about. Sure, the banks’ basic numbers — dividend yields and price-to-earnings ratios — continue to look good. But there are some underlying factors that are cause for concern – such as its purchase of auto lender Ally Canada. But if Ally is excluded, the Royal’s results are nowhere near as attractive.

Moreover, all the banks are over-exposed to consumer debt, particularly home mortgages — something it seems investors are finally beginning to realize.

All told, the Canadian stock market, when it comes to the entire retail banking sector, is not only weak, but very vulnerable to the inevitable rise in interest rates.

Yet, so far, the powers that be have bought into the idea that the banks’ financial health is vital to our economy.

As a result, they’ve been protecting the banks with artificially low interest rates.

Still, the tide may finally be turning. The loonie’s drop to $0.94 from around par with the U.S. dollar, gives the Bank of Canada some wiggle room on interest rates.

The BOC, of course, may pass up the opportunity, arguing that a lower loonie boosts exports. Although that’s true, it’s not all that important.

In fact, exports are far more dependent on the economic strength of our trading partners — mainly, our friendly neighbor to the South.

Indeed, the recent drop in the loonie reflects a recovering U.S. economy. And if the recovery actually lasts, it will fuel a rise in our exports. They’ll need no help from low interest rates.

Although the Bank of Canada is adamant rates will stay low, yields on long-term corporate debt are starting to rise.

Normally, this would also push up short-term rates. Yet, so far, the BOC, along with other central banks, have managed to prevent that, although they may not be able to continue to do so.

They likely realize this. But they’re probably afraid of raising rates in case it torpedoes the “recovery.” Nonetheless, in this regard, they’re taking, or trying to take, some baby steps.

Elsewhere, the U.S. Federal Reserve is finally starting to pull back, cutting its monthly infusion of new cash to US$75 from $85 billion.

Although the Fed’s move is a step in the right direction, it’s one that other countries, particularly in Europe, need to start thinking of doing.

Meanwhile, back in Canada, economists are admitting the real estate market is over-heated. They’re calling for a drop with a soft landing which, truth be told, may not be all that soft.

Practitioners of the “dismal science” are also sounding the alarm in other areas, warning that Canadians now carry too much debt.

Measures seem weak

But mild attempts to get consumers to scale back don’t seem to be working.

What will be needed to force a change in behavior is a sharp rise in interest rates. Although baby steps may be fine, they aren’t going to be enough.

Despite all the uncertainty, stocks keep rising. What little banks have lost, other sectors have made up.

What does all this mean to you, the ordinary investor? Well, it’s difficult to say.

Maybe it’s time you took some profits from your Canadian bank stocks, as well as from any other holdings that seem overpriced. But what you should then do with your profits remains unclear.

Utilities sector has done well

As I’ve noted before, utilities in these uncertain times have performed well.

And they’ll likely fall less in any market correction than other types of stocks. Yet, given the current situation, you shouldn’t put any money in utilities either.

What you should do is keep up to 20 per cent of your portfolio relatively liquid. Of that 20 per cent, keep up to a five per cent in gold or gold stock certificates.

You could buy the gold stock certificates issued by the Central Fund of Canada Ltd. (CEF.A-TSX, $14.05), a Calgary-based closed-end fund that holds both gold and silver bullion.

Or, you could buy the exchange-traded receipts put out by the Royal Canadian Mint (MNT-TSX, $13.63).

I won’t say that gold stock certificates are no substitute for bullion. Nor do I fear the global monetary systems is in imminent danger of collapse. I’m no Cassandra.

But all the signs point to a correction in the overall market, as well as to a sharp rise in interest rates. So, caution is now the order of the day.

T. Edward Gardiner, a Bell Canada retiree, is a keen observer of the markets. He lives in Ottawa.


Investor’s Digest of Canada, MPL Communications Inc.
133 Richmond St.W., Toronto, ON, M5H 3M8. 1-800-804-8846


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